Question

Consider the following information for three stocks, Stock A, Stock B, and Stock C. The returns on each of the three stocks are positively correlated, but they are not perfectly correlated. (That is, all of the correlation coefficients are between 0 and 1.)
Stock - Expected Return - Standard Deviation - Beta
Stock A - 10% - 20% - 1.0
Stock B - 10 - 20 - 1.0
Stock C - 12 - 20 - 1.4
Portfolio P has half of its funds invested in Stock A and half invested in Stock B. Portfolio Q has one third of its funds invested in each of the three stocks. The risk-free rate is 5%, and the market is in equilibrium.
What is the market risk premium RPM?
a. 4.5%
b. 5.0%
c. 6.0%
d. 5.5%
e. 4.0%

Answer 1

Answer:

b. 5.0%

Explanation:

For this question, we use the Capital Asset Pricing model (CAPM) formula that is shown below:

Expected rate of return = Risk-free rate of return + Beta × (Market rate of return - Risk-free rate of return)

where,

The Market rate of return - Risk-free rate of return) is also known as the market risk premium

So, for stock A, the market risk premium is

10% = 5% + 1.0 × market risk premium

10 - 5% = 1.0  × market risk premium

5% ÷ 1.0 = market risk premium

So, the market risk premium is 5.0%